Chapter Six

Audit of the Capital Acquisition and Repayment Cycle

 6.1 Overview of the cycle

• This cycle concerns the acquisition of capital

resources through interest-bearing debt and
owners’ equity and the repayment of the
capital.
• This cycle also includes the payment of
interest and dividends.
Cont.
• Relatively few transactions affect the account balances, but each

transaction is often highly material.

• For example, bonds are infrequently issued by companies, but the

amount of a bond issue is normally large.

• Their size makes it common for auditors, as a part of verifying the

balance sheet accounts, to verify each transaction taking place in the

cycle for the entire year.

• Audit schedules for most accounts in the cycle include the

beginning balance of every account, every transaction that occurred

during the year and the ending balance.
cont.

• The exclusion or misstatement of a single

transaction can be material.
• As a result, the auditor’s primary emphasis in
auditing these accounts is often on the
completeness and accuracy the recorded balance.
• The auditor must determine whether the client has
met the requirements of debt or equity agreements.
Cont.
• In the audit of the transactions and amounts in the
cycle, the auditor must take great care to make sure
the significant legal requirements affecting the
financial statements have been met and adequately
presented and disclosed in the statements.

• A direct relationship exists between the interest

and dividends accounts and debt and equity.
 Cont.
• In the audit of interest-bearing debt, auditors should
simultaneously verify the related interest expense and
interest payable.
• This is also true for owners’ equity, dividends declared,
and dividends payable
• This transaction cycle relates to the acquisition of capital
resources in the form of interest bearing note and owner
equity and repayment of capital.
• That is, it begins with acquisition of capital resources
and ends with repayment of capital.
Cont.
 Accounts in the cycle  Bond payable
 Notes payable  Donated capital
 Capital stock  Interest expense
 Contract payables  Dividend declared
 Mortgages payable  Cash in Bank
 Paid in capital in excess  Dividend payable
of capital
Cont.

• Four characteristics of the cycle significantly

influence the audit of these accounts:

1. Few transaction, that are highly material in

amount affect the account balances

2. The exclusion of a single transaction could be

material in its self or Omission of single
transaction could materially affect the financial
Statements.
Cont.
3. Existence of legal relationship b/n the client entity and
holder of equity, bond.
• The Auditor should consider whether the client has met the
requirement of the debt or equity agreements.

4. Direct relationship b/n interest and dividends account and

debt and equity accounts.
• Therefore, the auditor should simultaneously verify Interest
expense and interest payable and dividends declared, and
dividends payable.
6.2 Auditing Long-term debt

• Source and Nature of Debt

• Long-term debt usually is substantial in amount and often

extends for periods of 20 years or more.

• Debentures, secured bonds, and notes payable (sometimes

secured by mortgages or trust deeds) are the principal types

of long-term debt.

• Debenture bonds are backed only by the general credit of

the issuing corporation and not by liens on specific assets.

 Cont.
• Because in most respects debentures have the characteristics

of other corporate bonds, we shall use the term bonds to

include both debentures and secured bonds payable.

• The formal document creating bond indebtedness is called the

indenture or trust indenture.

• When creditors supply capital on a long-term basis, they often

insist upon placing certain restrictions on the borrowing
company.
 The Auditors’ objective in auditing debt

The auditors’ objectives in the audit of debt are to:

1. Use the understanding of the client and its
environment to consider inherent risks, including
fraud risks, related to debt.
2. Obtain an understanding of internal control over debt.
3. Assess the risks of material misstatement and design
tests of controls and substantive procedures that:
 :-

i. Substantiate the existence of debt and the occurrence of the related

transactions.

ii. Establish the completeness of recorded debt.

iii. Verify the cutoff of transactions affecting debt.

iv. Determine that the client has obligations to pay the recorded debt.

v. Establish the proper valuation of debt and the accuracy of

transactions affecting debt.

vi. Determine that the presentation and disclosure of information about

debt are appropriate, including disclosure of major provisions of loan

agreements.
 Internal Control over Debt
• Authorization by the Board of Directors

• Effective internal control over debt begins with the

authorization to incur the debt.

• The bylaws of a corporation usually require that the

board of directors approve borrowing.

• The treasurer of the corporation will prepare a report

on any proposed financing.

 Cont.
• Authorization by the board of directors will include review and

approval of such matters as the choice of a bank or trustee, the

type of security, registration with the SEC, agreements with

investment bankers, compliance with requirements of the state of

incorporation, and listing of bonds on a securities exchange.

• After the issuance of long-term debt, the board of directors should

receive a report stating the net amount received and its

disposition, for example, as acquisition of plant assets, as addition

to working capital, or for other purposes.

 Cont.
• Use of an Independent Trustee

• Bond issues are always for large amounts. Therefore, only relatively large

companies issue bonds; small companies obtain long-term capital through

mortgage loans or other sources. The trustee is charged with the protection of the

creditors’ interests and with monitoring the issuing company’s compliance with

the provisions of the indenture.

• Use of an independent trustee largely solves the problem of internal control over

bonds payable.

• Internal control is strengthened by the fact that the trustee does not have access

to the issuing company’s assets or accounting records and the fact that the trustee

is a large financial institution with legal responsibility for its actions .

Cont.

• Interest Payments on Bonds and Notes

Payable
• Many corporations assign the entire task of

paying interest to the trustee for either bearer

bonds or registered bonds.

 Cont.
• After obtaining an understanding of the client and its environment, the auditors

will assess the risks of material misstatement and design further audit

procedures for debt.

• To document internal control, the auditors will usually prepare a written

description, as well as an internal control questionnaire.

• Questions included on a typical questionnaire are the following:

1. Are amounts of new debt authorized by appropriate management?

2. Is an independent trustee used for all bond issues?

3. Does a company official monitor compliance with debt provisions? Therefore,

testing of controls occurs through what actually amounts to dual-purpose

transaction testing.
 Cont.
• Audit procedures appropriate for the verification
of debt include the following:
1. Obtain or prepare analyses of debt accounts and
related interest, premium, and dis- count accounts.
2. Examine copies of notes payable and supporting
documents.
3. Confirm debt with payees or appropriate third
parties.
4. Vouch borrowing and repayment transactions to
supporting documents.
5. Perform analytical procedures or data analytics to
test the reasonableness of interest- bearing debt and
interest expense.
Cont.
6. Test the valuation of debt, computation of interest
expense, interest payable, and amortization of discount
or premium.
7. Evaluate whether debt provisions have been met.
8. Trace authority for issuance of debt to the corporate
minutes.
9. Review notes payable paid or renewed after the balance
sheet date.
10. Perform procedures to identify notes payable to related
parties.
11. Send confirmation letters to financial institutions to
obtain information about financing arrangements.
12. Evaluate proper financial statement presentation and
disclosure of debt and related transactions.
 Auditing notes payable
• Objective of audit of notes payable is to
verify:
The internal control over notes payable are
adequate
Transaction for principal and interest involving
notes payable are property authorized and
recorded
Internal control over notes payable:
• Proper authorization for the issue of new NP

• Adequate control over the repayment of principal and

interest
• Proper document and records

• Periodic independent verification

• Reconcile notes recorded to general ledger

• Reconcile notes record to note holders record

• Recomputed interest expense on notes to test the accuracy

and propriety of record keeping.
 Audit of Interest bearing debt
• Long term debt usually is substantial in amount and
often extends over a longer time period.

• Debenture, secured bond, and notes payable (sometimes

secured by mortgages or trust deeds) are the principal
types of long-term debt.

• Since in most respects, debenture has the characteristics

of other corporate bonds, we shall use the term bonds to
include both debentures and secured bonds payable.
 Cont.

• The formal document creating bond indebtedness is called the

indenture or trust indenture.

• When creditors supply capital on a long-term basis, they often

insist upon placing certain restrictions on the borrowing company.

• For example, the indenture often includes a restrictive covenant

that prohibits the company from declaring dividends unless the

amount of working capital is maintained above a specific amount.

 Cont.
• The acquisitions of plant and equipment, or the increasing of

material salaries, may be permitted only if the current ratio is

maintained at a specified level and if net income reaches a

designed amount.

• Another device for protecting the long-term creditors is the

requirement of a sinking fund or redemption fund to be held by a

trustee.

• If these restrictions are violated, the indenture may provide that the

entire debt is due on demand.

The auditors’ objectives in the audit of interest-bearing debt are
to:

• Consider internal control over interest-bearing debt

• Determine the existence of recorded interest-bearing debt

• Establish the completeness of recorded interest –bearing debt.

• Determine that the client has obligations to pay the recorded interest-bearing

debt.

• Establish the clerical accuracy of schedules of interest-bearing debt.

• Determine that the valuation of interest-bearing debt is in accordance with

required accounting principles.

• Determine that the presentation and disclosure of interest-bearing debt are

appropriate, including disclosures of the major provisions of loan agreements.

 Cont.
• In conjunction with the audit of interest-bearing debt, the auditors

will also obtain evidence about interest expense, interest payables

and bond discount and premium.

• Many of the principles related to accounts payable also apply to audit

of interest-bearing debt.

• As in the case of accounts payable, the understatement of debt is a

major potential audit problem.

• Related to disclosure of interest-bearing debt, the auditors must

determine whether the company has met requirements and

restrictions imposed upon it by debt agreements.
 Auditing Capital stock
• Sources and Nature of Owners’ Equity
• Owners’ equity for corporate clients consists of capital stock

accounts (preferred and common) and retained earnings.

• Balances in the capital stock accounts change when the

corporation issues or repurchases stock.

• Transfer of ownership of shares from one share- holder to

another does not affect the account balances.

• Retained earnings are normally increased by earnings and

decreased by dividend payments.

Cont.

• Additionally, a few journal entries (e.g., prior period

adjustments) may directly affect retained earnings.

• Transactions in the owners’ equity accounts are

generally few in number but material in amount.

• No change may occur during the year in the capital

stock accounts, and perhaps only one or two entries

will be made to the retained earnings account.

 Substantive test in Auditing Owners’
Equity
• Substantiate the existence of owners’ equity and the occurrence of

the related transactions.

• Establish the completeness of recorded owners’ equity.

• Verify the cutoff of transactions affecting owners’ equity.

• Establish the proper valuation of owners’ equity and the accuracy

of transactions affecting owners’ equity.

• Determine that the presentation and disclosure of information

about owners’ equity are appropriate.

 Cont.
• In conjunction with the audit of owners’ equity accounts, the

auditors will also obtain evidence about the related accounts of

dividends payable and capital stock discounts and premiums.

• Major accounts to be tested auditing owners’ equity:

 Capital and common stock

 Paid-in capital in excess of par

 Retained earnings and

 Dividends
Cont.
• There are four main concerns in auditing capital

stock and paid-in capital in excess of stock

Existing capital stock are recorded

Recorded capital stock transactions are authorized

and properly valued

Capital stock is properly valued

Capital stock is properly disclosed

 Internal Control over Owners’ Equity

• There are three principal elements of strong internal control over

capital stock and dividends:
1. Proper authorization of transactions by the board of directors
and corporate officers,
2. Segregation of duties in handling these transactions (preferably
the use of independent agents for stock registration and transfer
and for dividend payments), and
3. Maintenance of adequate records.
 Auditing Dividends

• Internal Control over Dividends

• The nature of internal control over the payment of dividends, as
in the case of stock issuance, depends primarily upon whether
the company performs the function of dividend payment itself or
utilizes the services of an independent dividend-paying agent.
• If an independent dividend-paying agent is used, the corporation
will provide the agent with a certified copy of the dividend
declaration and a check for the full amount of the dividend.
 Cont.
• The bank or trust company serving as stock transfer agent is usually

appointed to distribute the dividend because it maintains the

detailed records of stockholders.

• The agent issues dividend checks to the individual stockholders and

sends the corporation a list of the payments made.

• The use of an independent dividend-paying agent is to be

recommended from the standpoint of internal control, as it

materially reduces the possibility of fraud or error arising in

connection with the distribution of dividends.

 Cont.
• In a small corporation that does not use the services of a dividend-

paying agent; the responsibility for payment of dividends is

usually lodged with the treasurer and the secretary.

• After declaration of a dividend by the board of directors, the

secretary prepares a list of stockholders as of the date of record,

the number of shares held by each, and the amount of the dividend

each is to receive.

• The total of these individual amounts is proved by multiplying the

dividend per share by the total number of outstanding shares.

 Cont.
• Dividend checks controlled by serial numbers are drawn payable to

individual stock- holders in the amounts shown on the list described above.

• The stockholder list and dividend checks are submitted to the treasurer for

approval and signature.

• The checks should be reconciled by the treasurer with the total of shares

outstanding and mailed without again coming under control of the officer

who prepared them.

• Cash in the amount of the total dividend is then transferred from the

general bank account to a separate dividend bank account.

Cont.

• The emphasis in audit of dividends is on the

transaction rather than the ending balance.

• Dividends are audited on 100% basis and cause

few problems.
Cont.
• The following are the most important objectives, including

those concerning dividend payable:

 Recorded dividends are authorized

 Existing dividends are recorded

 Dividends are properly valued

 Dividends as paid to stockholders are valid

 Dividends payable are recorded

 Dividends payable are properly valued

Cont.
• The review of dividend procedures for both cash
and stock dividends
• In the verification of cash dividends, the auditors
usually, perform the following steps
– Determine the dates and amounts of dividends authorized

– Verify the amounts paid

– Determine the amount of any preferred dividend is arrears

– Review the treatment of unclaimed dividend checks.

Cont.
• The auditors’ analysis of divided declarations may
reveal the existence of cash dividends declared but
not paid.
• These dividends must be shown as liabilities in the
balances sheet.
• The auditors also may review the procedures for
handling unclaimed dividends and ascertain that
these items are recognized as liabilities.
Cont.
• The amount of any accumulated divided in arrears
on preferred stock should be computed.
• In the verification of dividend there is additional
responsibility of determining that the proper
amounts have been transferred from retained
earnings to capital stock and paid-in-capital
accounts for both large and small stock dividends.
 Cont.
• Presentations- the presentations of capital stock in the
balance sheet include a complete description of each
issue.
• Information to be disclosed includes the title of each
issue; par or stated value; dividend rate, in any; dividend
preference; conversion and call provisions; number of
shares authorized, issued and in treasure; dividends in
arrears if any ; and shares reserved for stock options or
for conversions.
Cont.
• Treasury stock preferably is shown in the stockholders’ equity

section, at cost, as a deduction from the combined total of paid-

in capital and retained earnings.

• Changes in retained earnings during the year may be shown in a

separate statement or combined with the income statement.

• One of the most significant points to consider in determining the

presentation of retained earnings in the balance sheet is the

existence of any restriction on the use of this retained income.
Cont.

• Disclosure-In evaluating client disclosure, the auditor must be aware

that changes in retained earnings during the year may be shown in a

separate statement or combined with the income statement. A

combined statement of income and retained earnings often is

presented.

• In this form of presentation, the amount of retained earnings at the

beginning of the year is added to the net income figure, dividends

declared are subtracted from the subtotal, and the final figure

represents the new balances of retained earnings.

Cont.

• Existence of any restriction on the use of

retained that might be resulted from the
agreements with banks, bondholders, and other
creditors commonly impose limitations on the
payment of dividends etc must be fully
disclosed in the note to the financial statements.
Auditing Retained Earnings
• The audit work of retained earnings and dividends includes two

major steps. These are:

• The review of retained earnings and any appropriation of

retained earnings- the auditors should review the changes in

retained earnings during the year.

• Credits to retained earning accounts ordinarily represent

amounts of net income transferred from the income summary

account.
 Cont.
• Debit to Retained earnings accounts ordinarily includes

entries for net losses, cash and stock dividends, and for the

creations or enlargement of appropriated reserve.

• Appropriation of retained earnings requires specific

authorization by the board of directors.

• The only verification necessary for these entries is to

ascertain that the dates and amounts correspond to the

actions of the board.

Your patience is
much
appreciated